Bernanke lays out plan for tighter money

By Jennifer Liberto, senior writerFebruary 10, 2010: 4:19 PM ET

WASHINGTON (CNNMoney.com) -- Federal Reserve Chairman Ben Bernanke unveiled a blueprint Wednesday for pulling back the trillions of dollars the central bank has provided to prop up the nation's economy.

"These programs, which imposed no cost on the taxpayer, were a critical part of the government's efforts to stabilize the financial system and restart the flow of credit," Bernanke wrote in testimony for a Capitol Hill hearing that was postponed due to snow. "As financial conditions have improved, the Federal Reserve has substantially phased out these lending programs."

But Bernanke also emphasized that the U.S. economy still needs the support of easy money policies. He wrote that "at some point" in the future the Fed will "need to tighten financial conditions" by raising short-term interest rates and reversing programs that pumped liquidity into the markets.

The markets have been waiting to hear an inkling of how the Fed plans to start raising rates and pulling back on the trillions the Fed has pumped into the financial system since it started teetering on the edge of collapse back in late 2008.

For the last 18 months, the Fed has bought mortgages, long-term Treasurys and the debt of mortgage finance firms Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500).

Currently, the Fed holds $2.29 trillion on its balance sheets, up from $934 billion in September 2008, when the financial crisis really kicked into gear.

On Wednesday, Bernanke laid out a plan to sell some of those mortgages, Treasurys and debt, by offering what's called reverse repurchasing agreements. Under those agreements, the Fed sells its securities to a third party while agreeing to rebuy them at some point in the future.

The second way the Fed plans to soak up money is to sell banks and financial firms the equivalent of certificates of deposit. In this case, the Fed gets a chunk of the bank's reserves in exchange for paying interest at a steady rate.Dubbed a "term deposit facility," these deposits would be auctioned off and banks couldn't count their investment in the Fed as cash or reserves.

"Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so," Bernanke wrote.

Bernanke said he planned to start testing out such programs this spring.

But he added that the "firming" of exit strategy policy would start with an increase in the interest rate paid on reserves, adding that the Fed could always take a more "rapid exit," by increasing the rate paid on reserves if the economy needed it.

Bernanke was supposed to testify before the House Financial Services Committee about unwinding emergency Fed liquidity programs. The hearing fell victim to the snow that has blanketed the nation's capital over the past five days, and has yet to be rescheduled. Instead, the Fed released Bernanke's statement.

Two weeks ago, the Fed left interest rates unchanged at near zero percent, pointing to improvement in business spending but adding the recovery is likely to be "moderate" for some time.

But one member, Kansas City Fed President Thomas Hoenig, voted against the Fed's latest statement, saying he thought economic conditions had improved enough so that the Fed should not be promising low rates for an "extended period." He was the first dissenting vote among Fed policymakers since January 2009.

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